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You’ve probably heard the adage, “never lend money to family or friends.” While there can be many benefits to initiating a loan between loved ones, this statement is usually said to warn of the potential consequences. Money can be tricky, and it can cause significant tension. While lending money to family or friends can seem like an easy option, there are major implications a lender must consider before partaking in this transaction. If you’re considering lending money to family or friends, there are certain steps you can take to help encourage a successful transaction.

When lending money to family or friends, you can avoid future relationship problems by deciding up front whether you’re providing a gift or a loan.

With a gift, you have no expectation of getting the money back. But be aware that gifts of more than $18,000 per person per year could make you (not the person receiving the gift) subject to the federal gift tax. If you’re married, you and your spouse could give an individual up to $36,000 per year with no gift tax. If the recipient is married, you and your spouse could give the two of them a combined $72,000 per year.

Keep in mind that gifts of any kind count, not just cash. If you give someone a car, jewelry or a house, the item’s value is a gift in the view of the IRS.

If you exceed the annual limits, you can apply the excess against your lifetime gift limit, which is $13.61 million ($27.22 million for married couples). Ask your accountant about filing Form 709 with your tax return. So, the vast majority of Americans could never incur a gift tax. Bear in mind, though, this could have consequences to your estate taxes, so be sure to consult both your financial planner and tax advisor before proceeding.

Loans are not considered gifts since you’re going to get the money back. But the IRS considers money you lend to a family member to be a loan only if you sign a loan agreement, charge interest and try to collect (to the point of hiring a debt collector or taking the borrower to court). If you fail to meet all three requirements, the IRS can say your loan was actually a gift that’s subject to the gift tax.

• What’s your current net worth and can you afford to invest in this venture?
• Are you willing to sue the borrower if they’re unable to pay back the loan?
• Are you willing to enforce penalties for late payments?
• Has the borrower tried all other options such as banks or credit unions? If so, are you willing to take on the risk if lending institutions aren’t?

If you’ve thoroughly analyzed these considerations and decide to continue with the loan, proceed cautiously and implement strategic courses of action that could improve your chances of a positive outcome.

It’s crucial to work with a qualified attorney to draft a legal loan agreement that will be signed by both parties. This agreement should include:

• The amount of money being lent. State this in numbers and letters to avoid claims of miscommunication. Don’t just write $5,000, print “five thousand dollars and no cents” on the document as well.
• The date the money is to be lent and returned. Be specific.
• The interest rate you’re charging for the loan. The IRS needs proof that this loan is not a gift. This means you must charge and collect interest following the rules for the��. The minimum interest rate varies based on the length of the loan. If you lend the money at no interest, the IRS can consider the loan a gift, making you liable for gift taxes.
• The repayment schedule that the borrower must follow. State whether you’ll require periodic payments, a balloon payment or some combination. Some repayment schedules include:��

1. Monthly payment of principal and interest.��This is called an amortized loan and works like your auto loan or home mortgage. In the early months, most of the payment is interest, with the bulk of the principal being repaid in the final months. Defaulting during the term of the loan means the borrower still owes most of the money they borrowed.
2. No monthly payments.��The full loan and all interest are to be repaid at the maturity date. This is good when borrowers have little money or income now, but it’s a higher risk for the lender, since it requires the borrower to come up with a substantial amount of money later.
3. Monthly payments of interest only.��Known as a “balloon” loan, this is a hybrid of the two. The monthly payments are smaller than the first example, but the final payment is smaller than the second example.

• Penalties for not meeting the above terms. You must state what the penalties are for missed payments and bounced checks. State the grace period and then assess the penalty. Failure to abide by the rules of the agreement could cause the IRS to conclude that this isn’t a true loan agreement. Some of these penalties may include:
• Adding costs to the loan.
• Taking ownership of collateral.
• Taking legal action.
• Ability to transfer the loan to another party.

While family members can charge interest rates below current market rates, the applicable federal rate is the minimum interest the lender can charge for loans more than $10,000. If you charge less than this rate, you’ll have to pay taxes on the unearned interest.

For example, Mary lent her son, John, money to buy a house, but she failed to charge interest. The IRS made Mary pay income taxes on the interest she didn’t get from John. Because John should have paid interest, he was granted a tax deduction on the mortgage interest he never actually paid. To the IRS, it didn’t matter that John borrowed the money��“interest-free.” He should have been paying interest, so he got the break anyway.
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Within the loan agreement, there should be an amortization table showing the amount of principal and interest paid. It should also show the balance due after each month for the duration of the loan.

If the borrower doesn’t pay you back, you may be entitled to take a tax deduction as a “bad debt” on your tax return. But to win this deduction, the IRS wants to know that you’ve tried everything to get the money back – which may include taking the borrower to court. Are you prepared to sue a family member? If not, then you’re not likely to get this deduction.

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Work with your accountant to determine what you will need to file, such as IRS form 1098, which lists how much interest the borrower paid during each year and IRS form 1099, which states how much interest you received on the loan. Ask what you must report on your tax return. Failure to complete these forms could result in significant tax consequences.

The biggest challenge with providing money to friends and family members is often emotional, not financial. Many people would do anything for their loved ones, but lending money to family or friends can put more than your finances at risk. To preserve your relationship, treat these loans as a professional transaction, just as you would if conducted through a bank or credit union.

Should you choose to engage in a family loan agreement, be sure to work with qualified tax and legal professionals. Ask the borrower for a detailed plan stating exactly what the money will be used for. Clearly communicate the terms of your family loan agreement and establish the repayment plan you want. You can even review their finances and help them establish a budget that includes your repayment schedule. This can take some of the pressure off your personal relationship and can help improve the outcome of the transaction overall.